March Investment Comments
The year is off to a better start for equities than many expected following a difficult 2022 when aggressive rate hikes to counter inflation weighed on sentiment. The move higher for stocks in 2023 has been prompted by the expectation that the Federal Reserve is nearing the end of its rate hike cycle as inflation retreats from its recent peak. Combine that with optimism regarding a reopening in China and a resilient labor market in the U.S., increasing hopes for a “soft landing” for the economy, and the move higher for equities is understandable.
To battle persistently high inflation the Federal Reserve has raised its benchmark interest rate by 4.5% since last March, to a range of 4.5%-4.75%. This represents the fastest pace of rate increases since the 1980s with the intention of cooling off the economy to bring down inflation. The tagline the Fed uses is that its policy operates with long and variable lags, but still, its efforts have not yet had quite the bite many expected.
With rates now in what the Fed deems “restrictive” territory, it has signaled a willingness to slow the pace of increases with an expected pause in the first half of this year to allow it to assess the impact of its actions more fully.
No slowdown in the economy was evident in the January jobs number, which came in well ahead of expectations. Payrolls increased by 517,000 in January, nearly double December’s gain and almost triple the consensus forecast. The number was strong enough to raise questions regarding potential distortions. Some have pointed to adjustments to seasonal factors as well as mild weather in January, but it is hard to bend this number into a negative signal about the about the state of the labor market. The unemployment rate of 3.4% is now at its lowest since 1969.
Labor market tightness is putting upward pressure on inflation. Wage growth slowed in January, with average hourly earnings up 4.4%, but remains high relative to historical levels and is propping up services inflation, which the Fed is watching closely as it has proven stickier than goods inflation. Chair Powell has repeatedly said he is specifically focusing on services inflation excluding housing, as he views it as a key risk to achieving price stability. The continuation of a robust labor market could mean the Fed will need to do more than is currently contemplated to bring inflation down to its 2% target.
The particularly strong jobs report modestly altered consensus expectations for rate hikes this year. Traders are now betting that the central bank will raise its benchmark rate in two more 0.25% increments (up from expectations for one increase prior to the jobs report) to a peak of between 5.0%-5.25% in July, matching the forecasts of Fed officials.
Many continue to harbor expectations for a rate cut later this year, but the Fed has consistently pushed back against this belief. Chair Powell has insisted the Fed will continue to hold policy restrictive until "the job is done," that the process is “likely to take quite a bit of time," and that “the expectation that inflation will go away quickly and painlessly" is not his base case. The Fed anticipates a reversal in the labor market later this year with the expectation the unemployment rate will rise by more than 1% to 4.6% by year end. The market clearly does not fully believe this, but the question is what might alter the Fed’s current course?
Overall inflation has slowed as energy and goods prices have come down, but as noted, services prices have been stubbornly resilient. The January consumer-price index showed inflation moderated slightly but there are concerns that the downward trend is beginning to level off. Headline inflation in the CPI report was 6.4% versus a year ago, down slightly from 6.5% in December and well off a peak of 9.1% last June. Core CPI, which excludes energy and food prices, rose 5.6%, down modestly from 5.7% in December. The most recent inflation reading from the Fed’s preferred inflation gauge, the PCE Price Index excluding food and energy, was 4.4% in December, down from 4.7% the prior month but still well ahead of the Fed’s targeted 2%.
Consumers continue to spend, but the data has been somewhat volatile. In January, sales at retailers increased 3% from December, following a decline in each of the prior two months. The January number was well ahead of expectations and the report showed broad strength across categories. Headwinds are expected in the coming months as households exhaust savings built up during the pandemic, but current signs indicate a continued willingness to spend.
The overall environment paints a somewhat confusing picture. Risk assets have been bid higher; the yield curve is deeply inverted, signaling recession; and many continue to anticipate rate cuts later this year. This combination doesn’t make a lot of sense unless you expect a “soft landing” scenario where we experience a shallow recession as inflation gradually trends lower. While a soft landing is certainly possible, the market seems to be pricing in a high likelihood of it happening. Current circumstances are unique, and a reasonable case can be made for things playing out that way, but history suggests it isn’t the likely path from here.
Multiples have increased since the start of the year and the forward P/E on the S&P 500 is currently about 18x, modestly above the 10-year average. Consensus expectations reflect low-single digit earnings growth in 2023 as the economy slows and companies manage pressure on profit margins.
Some of the pressures are starting to show. With most of the S&P 500 having reported Q4 earnings, EPS is expected to decline a mid-single digit percentage in the final quarter of 2022, the first decline since the third quarter of 2020. If there is a recession in 2023, it is unlikely we will achieve the modest earnings growth that is expected.
Given the elevated risk to earnings, a forward P/E multiple above the 10-year average with rates moving higher isn’t exactly an ideal backdrop for investors. However, there are always risks in the market and concerns often either never materialize or end not as badly as feared. If in this case they do, there should be attractive opportunities for investment.
Regardless, investing in growing, profitable companies at reasonable valuations remains a sensible plan for the long term.
James M. Skubik, CFA